Derivatives: Definition and How They Work

A derivative is a financial contract whose value depends on the price of an underlying asset, a group of assets, or a benchmark. Common uses include hedging risk, speculating on price movements, and gaining leveraged exposure to markets. Derivatives can be traded on regulated exchanges or over the counter (OTC).

Key takeaways
* Derivatives derive value from underlying assets (stocks, bonds, commodities, currencies, interest rates, indexes, and even weather).
* They trade on exchanges (standardized, regulated) or OTC (customized, higher counterparty risk).
* Many derivatives are leveraged, amplifying both potential gains and losses.
* Main contract types: futures, forwards, swaps, and options.

How derivatives work
* Parties enter contracts that transfer exposure to an underlying asset without necessarily exchanging the asset itself.
* Contract value moves with the price of the underlying. Participants can use derivatives to:
* Hedge—reduce exposure to price moves (e.g., an airline hedging fuel costs).
* Speculate—take a directional bet to profit from price changes.
* Leverage—control a large exposure using a relatively small amount of capital (margin).
* Exchange-traded derivatives are standardized and cleared through central counterparties, lowering counterparty risk. OTC derivatives are privately negotiated and carry greater counterparty (credit) risk.
* Many contracts are cash-settled, meaning gains and losses are settled in cash rather than by delivering the physical underlying asset.

Types of derivatives
Futures
* Standardized contracts traded on exchanges agreeing to buy or sell an asset at a specified price on a future date.
* Both parties are typically obligated to fulfill the contract unless they close the position beforehand. Many futures are closed out or cash-settled before delivery.
* Example: A company locks in an oil purchase price with a futures contract to avoid paying a higher market price later. Speculators can also trade the same contract without intending to take delivery.

Forwards
* Customized contracts between two parties to buy or sell an asset at an agreed price on a future date.
* Traded OTC and tailored in terms, size, and settlement. Greater counterparty risk because they’re not cleared through an exchange.
* Often used by corporations that need bespoke hedges (exact timing or quantity).

Swaps
* Agreements to exchange cash flows between counterparties (e.g., fixed-rate vs. floating-rate interest payments, or one currency’s cash flows for another’s).
* Common uses include converting variable-rate debt to fixed-rate exposure or managing currency and credit risks.
* Example: Two firms swap interest payments so one effectively pays fixed interest while the other pays floating, achieving their desired exposure.

Options
* Contracts that give the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified strike price before or at expiration.
* Buyers pay a premium; sellers (writers) receive the premium and face potential obligation if the option is exercised.
* Styles: American options can be exercised anytime before expiration; European options only at expiration.
* Example—protective put: An investor owning shares buys a put to cap downside risk. If the stock falls, exercising the put limits losses to the premium paid plus any remaining share value decline.

Special considerations
* Hedging vs. speculation: Hedging transfers existing risk (e.g., currency or commodity exposure); speculation takes on risk to seek profit.
* Leverage and margin: Many derivatives require only a fraction of the notional exposure up front, magnifying returns and losses.
* Valuation complexity: Pricing depends on the underlying, time to expiration, interest rates, dividends/carry costs, volatility, and market liquidity.
* Counterparty and systemic risk: OTC contracts expose parties to default risk; complex interconnected derivative positions can amplify system-wide stress.
* Liquidity and supply/demand: Market liquidity affects the ability to enter/exit positions and can cause derivative prices to diverge from underlying values.

Advantages and disadvantages
Advantages
* Lock in prices or rates to stabilize cash flows.
* Hedge against unfavorable movements (commodities, currencies, interest rates).
* Achieve leverage to magnify returns with limited upfront cash.
* Access otherwise hard-to-reach markets or create customized exposures.

Disadvantages
* Can be hard to value; pricing depends on multiple variables.
* OTC derivatives carry counterparty (credit) risk.
* Leverage increases potential losses and margin calls.
* Complexity can hide concentrated or correlated risks; supply/demand can affect liquidity and pricing.
* Market sentiment, not just fundamentals, influences derivative prices.

Quick FAQs
What are common examples of derivatives?
* Futures, forwards, swaps, options, and credit derivatives (e.g., credit default swaps).

Why do companies use derivatives?
* To hedge exposures (commodities, currencies, interest rates), stabilize budgets, and manage financing costs.

What are the main risks?
* Leverage, counterparty/default risk (OTC), valuation complexity, liquidity shortages, and potential systemic effects from large, interconnected positions.

Bottom line
Derivatives are versatile financial contracts that transfer, hedge, or create exposure to the price movements of underlying assets. They offer powerful tools for risk management and speculation but carry complexity, leverage-related risk, and potential counterparty and systemic risks. Understanding contract mechanics, settlement terms, and the underlying drivers of value is essential before trading or using derivatives in a portfolio.